Fundamentals of Banking Asymmetric Information Banking ECO 473

Fundamentals of Banking Asymmetric Information & Banking ECO 473 - Money & Banking Dr. D. Foster

Direct & Indirect Finance Most external financing is done through intermediaries.

Banks Reduce Transaction Costs • Banks reduce the cost of acquiring assets. • Many costs are fixed. • Bank assets are highly liquid. • Economies of scale. Ø e. g. , using standard loan contracts as legal fees are averaged over many loans • Transactions costs are very low for lines of credit.

Adverse Selection • Those most eager to make a deal are the least desirable to the other party. Ø Bad risks want loans. Ø Firms with lots of risk want to sell bonds. • Risk drives up interest rate & drives out low risk borrowers. Ø If this problem persists …

Moral Hazard • Post-contractual change in behavior that puts other party at increased risk. Ø Will borrower really be prudent and repay? Ø Will company really be prudent and max. profits? Ø Does insurance reduce vigilance? • Markets cannot form if this persists.

Principal-Agent Problems • The action of the agent is contrary to the desires of the principal. Ø Workers shirk at their jobs. Ø Managers are also agents - they work for ownersshareholders. Ø Can bond-holders and stock-holders really monitor the firm? • Problems: Enron, Arthur Anderson

How do Banks Deal with Asymmetries? • Screen borrowers. Ø Avoids free rider problems with information. • Requirements for collateral and net worth. Ø Shifts risk to the borrower; avoids adverse selection. Ø Also, mitigates moral hazard. • Imposing covenants and monitoring. Ø Reduces moral hazard. • Variable interest rates and credit rationing. Ø Some tolerance for risk. Should the government get involved with asymmetries?

Cases involving asymmetric information Enron -- Stock price: $83 Feb 2001; $0. 21 Dec 2001 -- Business: trading energy futures -- Overvalued assets; hid losses -- Downfall took Arthur Andersen -- Employee with 401 k in Enron lose out Bernie Madoff -- Wall Street banker since 1960 s -- Prominent philanthropist -- Client losses = $50 billion -- “Ponzi” scheme began in 1991 -- “Model” unreplicated; targeted charities

Fundamentals of Banking Asymmetric Information & Banking ECO 473 - Money & Banking Dr. D. Foster